Professor Mukherjee on Cross-Border Mergers and Acquisitions in Times of Globalisation

Associate Professor Rahul Mukherjee has co-authored “Financial Constraints, Institutions, and Foreign Ownership”, a working paper on the financial determinants of FDI in the case of liquidity-constrained target firms. The paper is related to a broader SNSF project, “Financial Globalization and Real Reallocation in the Market for Corporate Control”, that aims at providing a precise quantification of the gains from cross-border mergers and acquisitions. More details with Professor Mukherjee.

Why did you write this paper?

A long time ago, when I was a grad student – around 2007, which is like ages ago of course – I was a research assistant at the University of Michigan for a project with my then advisor, who later became co-author for this project. We were interested in what happened to emerging market economy (EME) firms during financial crises. At the time of the Asian Financial Crisis of 1997–98 there was this influential paper by Paul Krugman where he talked about “fire-sale FDI”, as well as several op-eds by local politicians and writers in EMEs, about how all these EME firms were being bought up by foreigners during crises to be later sold for profit, and it was seen as this perverse side of capitalism. Being economists who had worked on some of the beneficial effects of international capital flows, we were interested to see, ten years or so after the Asian Crisis, what had happened to these firms. Were these sold back for profit, as Krugman had claimed, or was it more that they were being held for as long as normal FDI?

You have to know that the way we think about FDI is that usually these relationships last very long. What we found in one paper, “Fire-sale FDI or Business as Usual?” – published in 2016 – was that whatever happened to the firms that were bought during the crisis looks very similar to whatever happens outside the crisis. So FDI during the crisis doesn’t seem that different from what it is outside the crisis. Sure, some firms, which were illiquid, were being bought up probably at lower prices, but on the other hand it didn’t seem that these purchases were bad in the sense that they were sold off quickly by foreigners to make a tidy profit. They might have been bought up because they were otherwise going to go bankrupt, meaning that they were actually “saved” in some sense by the foreign investors. What is more, we found that they were actually not being sold back at a faster rate than any of their normal-time counterparts, which is what you would expect to see if these were short-term profit-seeking investments by foreigners. Of course the composition of foreign firms buying during crisis does change, in that more foreign financial firms enter, for example, but it’s not the case that these foreign financial firms were somehow behaving differently than in a normal, non-crisis time. There was nothing perverse happening at the level of each firm in terms of FDI.

So, that’s how we got started, and then that got us thinking about whether finance matters for FDI in normal times. The general view that people have about FDI is that it’s very related to trade. For example, there’s this classic theory of FDI called the “proximity-concentration trade-off”, which says that you can either export to a market (i.e, concentrate your production in one country that may be far away from your export market), or you can build a plant in that market (which would be FDI) and service it without exporting, thereby increasing proximity to the market, but reducing the concentration of production since now you produce in more than one country. That’s where the new working paper comes in: we ask, Does FDI also matter in purely financial terms, and not only in the way a trade economist would think about it? Are there any financial determinants of FDI? And if so, how do technology, finance and institutions in the host country interact to determine FDI?

You develop a model in the paper. Can you tell us more about it?

The paper is about FDI from developed countries to EMEs. The model and the empirics make the following point: foreign firms, especially from developed markets, face economic trade-offs when they invest in an EME. In addition to their technological expertise, foreign firms have access to their domestic stock market and domestic banks, and so they can bring technology and finance in the EME, but on the other hand there are several risks in emerging markets arising from expropriation, corruption, volatile laws, political risks, etc., risks that are unique to these local markets. So we say, considering that there are these trade-offs, what would be nice for these investors to have is a local partner, either as a joint venture or a domestic co-owner when they acquire a firm in an EME, so that they can get some local expertise to navigate all these complexities in EMEs. What we most see in FDI is not a firm going in and building a new plant, but a firm buying existing firms with their plants, machines and so on. In the model we are looking at how these foreign firms organise their FDI: Do they take full ownership or do they keep a domestic partner? And so on. So our model relates the ownership structure of these foreign-owned domestic firms to how financially constrained the domestic firms are, as well as to the general financial development and institutions of the country.

What do you find regarding the financial determinants of FDI?

We find that in a country that is poor in institutions, so where it could be valuable to have a local partner, the foreign partner is much less likely to take full ownership of a firm, i.e., much more likely to have a domestic co-owner.

We also look at how finance matters for firms that are more financially constrained, We do so by using the measure of “external finance dependence”, which measures how much a particular industry is dependent on outside funds, say from banks, to finance itself. What we find is that if firms are in a more external-finance-dependent industry, they are more likely to be bought up by a foreign investor, which is kind of intuitive. Basically, these foreign investors have to pay a lower price for these firms because the firms domestically don’t have access to great financial markets and therefore cannot invest optimally, which means that their value to the foreign investor, who can invest optimally and bring additional value to the firm, is higher than it is to the local owner.

However, since the foreign investors also want the domestic co-owner to help them navigate the issues in EMEs, different kinds of ownership – full 100% ownership, 10% ownership (which is the minimum for it to be defined as FDI) and all levels of partial ownership in between – are seen in the data. In summary, the degree of foreign ownership depends on the trade-off between how much the local firm needs the foreigner’s financing and how much the foreigner needs the local partner’s help in navigating a corrupt environment. Both factors seem to matter a lot in how these foreign firms enter the market in the form of fully owning the subsidiary, or in partly owning it.

The paper is quite original in that it looks at FDI from a different point of view, at the fact that local institutions, finance and technology can interact in these ways, and presents a comprehensive view of the trade-offs involved for foreign investors in an EME.

The paper is related to a broader research project on mergers and acquisitions in the context of globalisation. Can you give some precisions?

The project is called “Financial Globalization and Real Reallocation in the Market for Corporate Control” and funded by the Swiss National Science Foundation (SNSF). It tries to understand the mergers and acquisitions (M&A) market. This is an important market to understand because it is a very large part of capital flows these days, even if it isn’t as important between developed and emerging markets as among developed markets. In the paper I was just telling you about, the foreign firms have full access to finance, while domestic firms are completely constrained. But what happens when both the acquirer and the target firm are financially constrained? This is what we try to model in another co-authored paper titled “Acquirers and Financial Constraints: Theory and Evidence from Emerging Markets”. This could also be applied to the market in the United States and Europe, where there is better data on a large range of firms, some of which are very big and financially unconstrained and some of which have some degree of financial constraint. How does the M&A market behave in this situation when there is a recession?

Where this idea fits into the bigger picture is in the economics of the so-called “cleansing effect” of recessions, which claims that when there are recessions or big financial crises, the not-so-efficient firms are wiped out in a kind of Darwinian effect that improves the aggregate productivity and the aggregate allocation of resources between firms. What we think this literature has so far overlooked is that nowadays the acquisitions market is large, and increasingly cross-border. So when a European firm is in trouble, a US firm can come in and buy it and vice-versa. We wanted to know what would happen if there is a major recession or major (financial) crisis that affects some firms but not others, where some are financially constrained but not others.

We find that there can be interesting selection effects going on, which are as follows: when a financial crisis hits a country, essentially the only firms still being able to buy and sell other firms are the best ones in the market and also likely the most productive ones. This is somewhat counterintuitive because in a crisis everything is in turmoil and bad matches are expected to take place, which is what Krugman was hinting at. But since in general acquirers themselves are constrained, actually they go after firms with which they have greater synergies during a crisis. There is a literature on emerging markets that shows that there are larger gains from synergies when you acquire bigger stakes. The natural consequence of that would be if you seek bigger synergies during a crisis, you would also acquire bigger stakes and also hold on to these longer because they are better matches. We find some suggestive evidence from emerging markets that this is in fact what is happening. We show that the domestic investors in emerging markets who acquire during a crisis buy, unlike foreign investors, larger shares of the firms and hold on to these for longer. That could be for two reasons: either because these are fundamentally better matches, for which we find some evidence, or because these firms are less likely to be in trouble in the future themselves so that they don’t have to sell.

The SNSF project aims to investigate the broad and general question of the gains from globalisation that arise out of financial constraints of firms being relieved, and not only due to risk sharing or technology transfer across countries, as it is generally looked at. The M&A market is a great place to start looking because here there is transfer of technology as well as of financial resources going on. We are trying to get together a firm-level dataset for Europe and some parts of the rest of the world where there is this kind of data. We want to see what happens to acquirer and target firms before and after acquisitions, to see for instance if there is an improvement in productivity and/or an improvement in investment for the target and if we can disentangle the two. So we are trying to build a general equilibrium model that measures the gains of globalisation that accrue through the international market for corporate control.

Read “Fire-sale FDI or Business as Usual?” >Full citation of the article: Alquist, Ron, Rahul Mukherjee, and Linda Tesar. “Fire-sale FDI or Business as Usual?” Journal of International Economics 98 (2016): 93–113. doi:10.1016/j.jinteco.2015.09.003.